On the day that the board of the Reserve Bank meets to decide the future of interest rates for the next month, it’s worth considering how franchisees and independent business owners can become too comfortable with too much debt.
To illustrate this concept, let’s start with home loan debt, before moving on to business debt.
For a first time home owner, the process of buying a home is daunting even before coming to terms with the idea of a mortgage lasting 20 years or longer.
To firstly even qualify for a home loan, the buyer has to scrimp and save to get their five or 10% deposit together, plus demonstrate a sustainable income by which to repay the loan.
If the buyer wants to save money by avoiding the need for loan insurance, then he will scrimp and save even longer to get a 20% deposit (acknowleding of course that the opportunity cost of buying a home sooner may be greater than waiting until an even larger deposit is available.
Either way, the buyer has built up a deposit in order to qualify for the loan, then presto, they are a home owner.
After some time of home ownership, the property has hopefully gone up in value, and the owner has paid the interest (and hopefully made a dent in the principal amount) on the loan.
Perhaps by this time he is also tired of his job, and looking to get into a business of his own, so starts looking at franchises, and presto (again), finds a franchise he would like to buy.
However, to pay for it he needs money. He doesn’t have savings because he’s shovelled all his cash into his home loan, so instead asks the bank to give him a business loan secured against the equity in his home (or may even draw directly from the home loan itself if it provides equity access).
In effect, the buyer has parlayed his initial home deposit into a deposit on his franchise. He now has a home loan and a business loan/debt.
Fast forward a year or so, and the buyer – now franchisee – has found a magnificent opportunity to open or buy an additional outlet or territory for his franchise business.
This time, the equity in his home is stretched across a third loan facility, until another year passes when he buys yet another outlet.
With no more equity in his home available to borrow against, the franchisee seeks to fund 100% of the loan for the new business based on the cash flow of the other two existing outlets.
This cycle may be repeated one or more times as the franchisee entrepreneur builds his business empire with the encouragement of the franchisor, who also derives benefit from the growth of their network, the comparitive ease of growing with an existing operator than breaking-in a new one, and the growth in royalty income.
Then one day something happens to disrupt the flow of cash that has been sustaining the loan repayments on the business empire, and all hell breaks loose.
Perhaps one of the businesses needs a major refurbishment for which the owner has not made provision? Perhaps some key staff leave and their customers follow? Perhaps a competitor opens near one or more of the outlets? Perhaps access to one of the stores is restricted by road or building works?
Perhaps the franchisee has made investments outside of the franchise (a common trait of multiple-unit franchisee), which may now need an injection of cash for which the business is the only available source of money? Perhaps there has been a relationship breakdown and the business owner needs to pay out a former partner?
In such instances, a business’s cash flow can be put under stress to deal with the loan repayments and other demands imposed on it.
Perhaps, in a moment of inspiration, the owner decides to free up cash in his business by changing his business loans from principal and interest, to interest only.
And then perhaps there is another setback in one or more of the businesses, and then the franchisee’s cash flow is no longer capable of dealing with his competing demands, and somebody stops getting paid (with the somebody typically being the franchisor, the bank, the Tax Office, suppliers, staff superannuation funds, or any and all of these).
Now suddenly the franchisee is in a world of hurt. His profile as a successful businessman takes a hit as creditors move to recover their security, and the businesses – and perhaps even the house from which this all started – are liquidated at fire sale prices.
Watching helplessly in the centre of this maelstrom is the franchisee. Like other people in his position before or since, he will blame others for his demise:
- “It was the franchisor’s fault for letting me have too many outlets.”
- “It was the bank’s fault for not being flexible enough.”
- “It was the government’s fault for charging too much tax.”
- “It was the union’s fault for forcing wages too high.”
- “It was the landlord’s fault for charging too much rent.”
- “It was the supplier’s fault for stopping my credit.”
With all this externalising of responsibility, the franchisee may never properly come to the realisation that it may actually have been their own fault for borrowing too much money, and for not taking proper steps to pay it back as quickly as possible.
So when the Reserve Bank board considers interest rates today, ask yourself how comfortable you really are with your level of business debt, and whether continued low interest rates represent an opportunity to borrow more, or pay more back?
Jason Gehrke is the director of the Franchise Advisory Centre and has been involved in franchising for 20 years at franchisee, franchisor and adviser level.
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